Amazon (AMZN) prides itself on its robust cash flow, excellent customer service and outright commitment to the lowest consumer prices. Notwithstanding these noble goals and a $118 billion market capitalization, investors need to ask themselves three questions:
- What is Amazon really worth;
- What catalysts could trigger a share price collapse; and
- When could this happen?
To answer these questions, I have constructed a sum-of-the-parts (SOTP) valuation approach below, individually valuing each of Amazon's key business units. Based on the SOTP valuation, I have then analyzed what events could trigger a sharp revision to Amazon's long-term outlook and share price.
Question 1: What is Amazon really worth? SOTP Valuation Approach:
While some of Amazon's reporting could be considered opaque, few would dispute the core businesses within the enterprise that make up the underlying valuation, including:
- Amazon Web Services (AWS)
- Online Retailing & Fulfilment by Amazon (FBA)
- E-book business including E-readers and Kindle Direct Publishing (KDP)
Taking each of these in isolation:
1. Amazon Web Services
AWS is best described as a cloud computing services business which provides customers with dedicated cloud and public cloud hosting capabilities. Amazon's 2011 annual report states that the company has "thousands of large and small business…customers."
While AWS is not broken out specifically in the accounts, the Q2 2012 accounts state that net sales under the "Other" category were $554 million which, according to the footnotes, include AWS. For the purposes of this valuation, I will assume that 100% of "Other" sales were linked to AWS.
The cloud computing space is getting extremely crowded and includes giants such as IBM, Google (GOOG), Apple (AAPL) and Microsoft (MSFT) among others. Rackspace Holdings (RAX) is one of the few publicly quoted pure plays in the sector and I have therefore used them for comparable analysis purposes.
RAX, which has 172,000 business customers, had a Q2 2012 turnover of $319 million and made a net profit margin of just under 8%, highlighting the competitiveness in this marketplace. While I refrain from opining on RAX's valuation, it is currently trading at a record high of 99x P/E, valuing the business at over $9 billion. Using the same metrics, AWS, which has 74% higher turnover than RAX, would be valued at $15.6 billion.
2. Online Retailing & Fulfillment By Amazon
Amazon does not break out the cash flow of each of its businesses, but we do know that operating cash flow, upon which Amazon encourages us to measure it by, has been approximately $3.2 billion for the last 12 months. While I will comment on the quality of that cash flow below, if we are to compare it with other retailers, Wal-Mart's (WMT) cash flow is approximately 8 times Amazon's and Tesco's (TESO), the world's third largest retailer, is 1.4 times Amazon's. Both Tesco and Wal-Mart are valued at approximately 10 times annual cash flow valuing Amazon's business on a comparable basis (assuming all operating cash flows came specifically from this division which they don't) at $32 billion.
3. E-book business including E-readers and KDP
Let's start with KDP. According to the Amazon 2011 annual report, "more than 1,000 KDP authors now each sell more than a thousand copies a month… A typical selling price for a KDP book is a reader friendly $2.99-authors get approximately $2 of that!"
While this does not give us exact figures, based on the above statements, we can make some reasonable assumptions:
- Number of KDP authors = 1,000-2,000
- Unit sales per month per author=1,000-2,000
- Unit revenue to Amazon=$1 per unit
In other words, Amazon is generating revenues of no more than $4 million per month or $48 million a year. Even with a 30% net margin (publishers like Bloomsbury who published Harry Potter typically make a 10% pre-tax margin), KDP would contribute $14.4 million pre-tax profit to its bottom line or approximately $10 million after tax. Publisher P/E multiples vary but rarely do they exceed 20x. Assigning an aggressive 50x P/E multiple would value the business at $500 million.
Regarding E-readers, in response to an SEC query last year, Amazon stated that neither the sales nor the margins on Kindles were material to Amazon's accounts. Equally, the Amazon pricing strategy has been to sell the Kindle at or around cost and make money on the sale of content. What reasonable value could we therefore place on the Amazon e-book business?
Our best comparable transaction is Microsoft's $300 million investment in Barnes & Noble's (BKS) Nook business early this year which also included its profitable "College" division. Microsoft valued the business at a pre-money valuation of $1.4 billion. It is fair to assume this is at a premium to what other buyers would willingly pay given that Nook, as part of the transaction, will swap out the current Google Android based operating system for Microsoft's operating platform. Nevertheless, BKS states in its 2011 annual report that it holds 27% of the e-book market. According to Authors Guild, Amazon is estimated to hold 60% of the e-book market, or just over 2 times BKS's share. On that basis, the value of the business would be at least twice BKS's value. I have assumed that it would be 6 times the value as the margins are likely to be higher for Amazon and its online scale provides distribution channels that BKS would not have. On that basis, the e-book/e-reader business is worth approximately $8.4 billion to Amazon.
Taken together, KDP and the e-book/e-reader businesses give a total enterprise value of $8.9 billion, which I have rounded up to a $10 billion valuation.
In summary, a SOTP valuation can be aggregated as follows:
- AWS $15.6 billion
- KDP and E-books $10.0 billion
- Online Retailing & Fulfillment $32.0 billion
- Enterprise Value $57.6 billion
- Enterprise Value/Share $125
- Current Share Price $257
Question 2: What catalysts could trigger a share price collapse?
Hindsight is a great skill to have and investors usually construct many fanciful theories around what ultimately triggered an eventual share price collapse in a stock. In reality, reduced barriers to entry or a lack of sustainable competitive advantages ultimately leads to lower prices, lower margins and decreasing returns on capital employed and, hence, a falling valuation. At a point in time, this trend becomes apparent to investors and there is usually a rush for the exits, particularly when there has been an extreme and unsustainable run up in the share price.
To determine a catalyst for an Amazon share price collapse, I have therefore reviewed the trend in Key Performance Indicators of the business in the table below, notably:
-Return on Equity and Return on Assets;
-Operating margins; and
-Cash Flow and Liquidity
Amazon operating metrics:
Growth Rate %
Cash Flow From Operations
Fixed Asset Purchases
Share Price High
Share Price Low
On every measure, Amazon's business is deteriorating rapidly.
Critically, Amazon has always sought to portray itself as a solid cash flow business which should be valued on a cash flow basis as we have discussed above. That argument however is very much dependent on the quality of those cash flows.
AIG Financial Products Group, the source of AIG's meltdown and ultimate multi-billion government bailout, also had solid cash flow initially through receiving large upfront premiums to issue credit default swaps, insuring all sorts of valueless structured credits. Essentially AIG was building up large contingent liabilities on its balance sheet which, when those liabilities were called in, AIG did not have sufficient cash to cover the margin calls.
In Amazon's case, its top line sales growth has fueled an expanding balance sheet with increasing liabilities. Those liabilities are primarily funded by suppliers on 30, 60 or 90 day credit terms. In most cases, Amazon receives immediate payment from customers hence the positive cash flow. However, if growth was to slow, and it clearly will this year, or suppliers were to tighten their credit terms, or get nervous about their counter party risk as was the case with AIG, they could easily put pressure on Amazon's balance sheet. As it stands today, Amazon would not have sufficient cash or liquid assets to pay those suppliers.
Q3. When are the catalysts likely to happen?
Any number of events could trigger a run on the share price, including distributors no longer supplying the Kindle e.g. Target (TGT) and Wal-Mart, outages at the company's AWS facilities, as per the apparent lightning strike last year, or sales taxes in California, which kicked in last week. An earnings miss this quarter, a deteriorating balance sheet or continued weak margins will ultimately bring about the share price downfall.
Amazon is guiding an operating loss for Q3 2012 of $50-$300 million and its guidance implies a growth rate in sales of 20% for 2012, half of the 2011 growth rate. For the immediate future, it would appear that the trend is only going to get worse before, and if, it gets better.
I would expect the share price to collapse right after the release of the Q3 2012 results based on a Q3 operating loss and guidance from the company of a breakeven Q4 2012 with a reduced growth rate in net sales of 20% year on year. In that scenario, the business will arguably be heading for insolvency and the underlying value of the business will revert to a SOTP valuation at best. Based on the analysis above, that implies a share price of between $0-125, a fall of 50-100% within 4-6 weeks.